Melting Down: Systemic Financial Instability and the Macroeconomy
41 Pages Posted: 6 Jul 2014 Last revised: 5 Mar 2015
Date Written: February 28, 2015
Abstract
We investigate the role of systemic financial instability in an empirical macrofinancial model for the euro area, employing a richly specified Markov-Switching Vector Autoregression model to capture the dynamic relationships between a set of core macroeconomic variables and a novel indicator of systemic financial stress. We find that at times of widespread financial instability the macroeconomy functions fundamentally differently from tranquil times. Not only the variances of the shocks, but also the parameters that capture the transmission of shocks change regime, especially around times of high systemic stress in the financial system. In particular, financial shocks are larger and their e¤ects on real activity propagate much more strongly during high systemic-stress regimes than during tranquil times. We find an economically important role of lending in the propagation of financial stress to the macroeconomy. We also show that prospects for detecting high systemic stress episodes appear promising, although we argue that more research is required. We conclude that macroprudential policy makers are well advised to take these non-linearities into account.
Keywords: financial stability, systemic risk, macro-financial linkages, Markov switching VAR, non-linearities
JEL Classification: E44, C11, C32
Suggested Citation: Suggested Citation
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